Wednesday, 4 June 2014
"What lessons have we learnt from the Global Financial Crisis?"
Professor Robert Marks
In 2008, the world suffered "the equivalent of cardiac arrest", according to the Financial Times. It became virtually impossible for any institution to finance itself, (that is, borrow in the markets) longer than overnight. With the collapse of Lehman Bros, interbank credit markets froze and counterparty risk was considered to be too great for prospective lenders to take on the transactions. The London interbank overnight lending rate, typically in the range of 0.2% to 0.8% spiked to over 3%. This situation raises two questions: what caused this global financial crisis (GFC)? and how can we attempt to avoid similar crises in the future? The origins of the crisis go back more than 30 years.
Starting in 1977, there were substantial changes made to US investment legislation. Early in this period, the aim was to make finance more readily available to low-income borrowers, to progressively eliminate using the controls on mortgage rates and to remove discrimination in the US housing market. In 1999 and 2000, there was substantial deregulation, with substantial changes to long-standing legislation, in particular the repeal of the Glass-Steagall act of 1933 that had imposed restrictions banks during the Great Depression. There were also reforms to the Federal housing finance regulatory agencies, loosening their lending requirements.
This period of financial deregulation encouraged consolidation and demutualisation of many financial institutions that had been mutually or privately owned, with these being floated as public companies. Whereas previously their lending practices had been conservative as they had been risking their own money, now the money at risk belonged to other people! There was also great creativity in developing new financial products and instruments: Mortgage-Backed Securities (MBS), structured investment vehicles, Credit Default Swaps (CDS) and Collateral Mortgage Obligations (CMO).
In the early 2000s, the September 11 attacks, coming not long after the bursting of the "tech bubble", led to a prolonged period of low interest rates. US fiscal policy was heavily in deficit leading to massive issuance of US bonds that were largely bought by China and other Asian countries. At the same time there was further financial deregulation, relaxing capital requirements that encouraged higher gearing financial institutions.
Unsurprisingly, firms responded to the incentives put before them. The market for the new financial instruments boomed and rating agencies responded by changing the way in which they charge for their services – they began charging the firms whose products they were rating, rather than the potential buyers of the product. In the US, the financial sector grew from 3.5% of GDP in 1960 to nearly 8% of GDP in 2008.
Drawing these strands together, there were four causes of the GFC: the repeal of the Glass-Steagall act; the decision by Congress not to regulate derivatives; the relaxation of regulations that allowed banks to expand their gearing; and the change by the ratings agencies to charge the issuer rather than the buyer of rated products.
How likely is this type of situation to occur again in the near future?
Unfortunately, a number of European countries may be facing similar challenges unless they take steps to avoid the problems that the US experienced. Fortunately, Australia avoided the worst of the GFC, well-served by the "four pillars" banking policy. However, there needs to be recognition that information is asymmetric and that the issue is really not one of risk but rather of uncertainty, where there are no simple answers. As George Santayana observed in 1905, "those who cannot remember the past are condemned to repeat it".